CHAPTER 7

COVERAGE OF LEARNING OBJECTIVES

LEARNING
OBJECTIVES

QUESTION
S

EXERCISES

PROBLEMS

LO1: Link inventory

valuation to gross profit.
LO2: Use both perpetual
and periodic inventory
systems.
LO3: Calculate the cost of
merchandise acquired.

1, 30

31, 32, 43, 44

2, 3, 4, 5, 27

33, 35, 37, 38,

39, 40

53, 82

6, 7

52, 55

LO4: Compute income

and inventory values using
the three principal
inventory valuation
methods allowed under
both U.S.GAAP and IFRS,
and the one method
allowed only by U.S.
GAAP.
LO5: Use the lower-ofcost-or-market method to
value inventories under
both U.S.GAAP and IFRS
LO6: Show the effects of
inventory errors on
financial statements.
LO7: Evaluate the gross
profit percentage and
inventory turnover.
LO8: Describe
characteristics of LIFO
and how they affect the
measurement of Income
(Appendix 7A)
LO9: Determine inventory
costs for a manufacturing
company (Appendix 7B).

8, 9, 10, 11,
12, 13, 14, 15,
16, 28

31, 32, 35, 36,

38, 39, 40, 42,
43, 49
34, 41,47

17, 18

48

58, 74

19, 29

45

59, 66, 77, 83

20, 21, 30

42, 43, 44, 46,

49, 50, 51

32,54, 80

53, 56, 57, 58,

60, 61, 62, 63,
64, 67, 68, 69,
70,71, 72, 73

22, 23, 24, 25

65, 72, 73, 75,

76, 78, 79, 81

26

84

238

OTHER

85, 86,
88

86,87

CHAPTER 7
7-1

Cost of goods sold = Beginning inventory + Purchases Ending inventory.

7-2

Sales transactions are accompanied by recording of the cost of goods sold (or cost of
sales). This is literally true under the perpetual system and conceptually descriptive under
the periodic system.

7-3

The two steps are obtaining (1) a physical count and (2) a cost valuation.

7-4

Perpetual systems provide continuous inventory and cost of goods sold records. Periodic
systems rely on taking a physical inventory to calculate and record cost of goods sold at
the end of the period.

7-5

It is true that the periodic method requires a physical count to measure cost of goods sold
at year end and the perpetual method does not. However, for control purposes, it is also
important to undertake at least annual physical counts of inventory under the perpetual
method. The difference between what the accounting records show and the physical count
will be due to theft, spoilage, or other unrecorded changes.

7-6

F.O.B. destination means the shipper pays the freight bill. F.O.B shipping point means the
customer bears the cost of the freight bill. F.O.B. stands for free on board. The terms
also describe whether the seller or buyer owns the goods while they are in transit.

7-7

Freight out is not shown as a direct offset to sales. Unlike sales discounts and returns,
freight out is not a part of gross revenue that never gets collected. Instead, it is an
expense, entailing ordinary cash disbursements.

7-8

The four methods are:

1.
Specific identification charges the actual cost of the specific item sold.
2.
FIFO items purchased first are assumed to be sold first.
3.
LIFO items purchased most recently are assumed to be sold first.
4.
Weighted average the average cost of all items available is charged for each item
sold.

7-9

The specific identification method is normally used for low volume, high value items.
Therefore, we would expect this to be used for a, b, d, and f.

7-10

Yes. Under FIFO the oldest costs are assigned to the cost of goods sold first, so the same
cost of goods sold arises whether the costs are assigned at year end or as the sales occur.

7-11

The good news is that LIFO reduces taxes in times of rising prices. The bad news is that
reported profit is lower.

7-12

Yes. Purchases under LIFO can affect income immediately, because the unit costs of the
latest purchases in the period are assigned to units sold even if the purchases occur after
the sales occurred.
239

7-13

No. The weighted average must take into account the number of units purchased at each
price. For Gamma Company, the weighted average unit cost of inventory is: [(2 $4.00)
+ (4 $5.00)] 6 = $4.67.

7-14

Ending inventory is lower under LIFO in a period of rising prices and constant or growing
inventory. FIFO produces the higher ending inventory value.

7-15

Falling prices reverse the normal relation, so FIFO produces higher cost of goods sold
and, therefore, lower net earnings. This helps explain why computer and electronics firms
typically use FIFO in order to lower their taxes.

7-16

Companies have adopted LIFO primarily because it saves income taxes during times of
rising prices by reporting higher cost of goods sold and lower profits.

7-17

Under IFRS market is the net realizable value the net amount the company expects to
receive for the inventory. Under U. S. GAAP it is usually the current replacement cost
what it would cost to buy the inventory item today.

7-18

The inconsistency is the willingness of accountants to have replacement costs used as a

basis for write-downs below historical costs, even though a market exchange has not
occurred, but their unwillingness to have replacement costs used as a basis for write-ups
above historical costs.

7-19

Many inventory errors do counterbalance. For example, an ending inventory that is

overstated will overstate current income. But the same overstated inventory becomes the
beginning inventory the next year; hence, next years income will be understated. To show
this you might use the following schematic:
Year 1
BI
+ Purchase
Goods Available
Ending Inventory
Cost of Goods Sold

OK
OK
OK
Too Large
Too Small

Year 2
Too Large
OK
Too Large
OK
Too Large

This exercise stresses the fact that the ending inventory of one year becomes the beginning
inventory of the subsequent year and the errors correct themselves.
7-20

Past gross profit percentages are sometimes applied to current revenue as interim
estimates of gross profit for a month or quarter. Thus, the time and cost of taking physical
inventories can be saved by companies using the periodic inventory method.

7-21

Grocery stores have a low profit margin. If the profit margin is 2%, a savings of $100 in
shrinkage would be equivalent to a $5,000 increase in sales.
240

7-22

An inventory profit is fictitious because, for a going concern, it represents an amount

necessary for replenishing inventory and is therefore not available in the form of cash for
distribution as dividends. It arose from a change in unit costs of the products purchased,
not from the companys value-added activities.

7-23

LIFO inventory valuations can be absurd because inventory valuation is based on older
and older costs as the years pass. When a company has been in business for 100 years, its
original acquisition cost of an item is not informative.

7-24

The inventory holding gain is an increase in the value of inventory due to price changes
that occur while the inventory is held.

7-25

When LIFO layers are liquidated, older, generally lower cost items are reflected in cost of
goods sold and high profits are reported in the income statement. In other words, the
inventory holding gains are realized.

7-26

Manufacturing companies have raw material, work in process, and finished goods
inventories. The size of the various inventories will vary from industry to industry and
from season to season in many industries. Most often finished goods inventory will be the
largest and work in process inventory will be the smallest of the three inventories.

7-27

There are many advantages to a perpetual inventory system. It allows a continuous

tracking of inventories, allowing better control of inventory. This could include tracking
of sizes, colors, and other product characteristics, which could help manage production.
Its biggest disadvantage is cost; a periodic inventory system is simpler and less costly.
However, with the use of optical scanning and computers, the cost of a perpetual
inventory system has come down quickly. If the Zen Bootist is willing to invest in a
system that codes each individual product and tracks its progress through the inventories,
then many advantages of a perpetual inventory system can be achieved. If the inventory is
small enough for the owner to observe the inventory the sizes, colors, etc. without the
aid of an inventory report, the periodic method may be sufficient.

7-28

Under the FIFO method, the cost of sales will be based on old acquisition costs. Under
the LIFO method, the cost of sales will be based on the most recent acquisition costs.
Thus, under LIFO, if additional units are acquired on the last day of the year, the cost of
those units will be included in cost of sales. Thus, under LIFO, additional purchases
would produce higher cost of goods sold in this instance and lower evaluations for the
purchasing officer. Thus, under LIFO he would be less likely to purchase additional oil on
the last day of the year.

7-29

Phar Mor overstated its assets by overstating inventories. This means that either liabilities
or stockholders equity must also be overstated (to keep the balance sheet equation in
balance). Most likely Phar Mor used a periodic inventory method, so that overstating
ending inventory would reduce cost of goods sold and increase pretax profit. If the
company used a perpetual inventory system, management must have made inappropriate
credits to cost of goods sold or some other expense account to offset the additional debits
to the inventory account.
241

7-30

Your boss may have a point. It all depends on whether the discount generates additional
sales. If inventory turnover (sales average inventory) increases enough to offset the loss
of gross margin, the discount is worthwhile. If not, the discount is just giving money
away.

7-31

(1015 min.)
KUPERSTEINS JEWELRY WHOLESALERS
Schedule of Gross Profit
For the Year Ended December 31, 20X8
(In Thousands)

Gross sales
Deduct: Sales returns and allowances
Cash discounts on sales
Net sales
Cost of goods sold:
Inventory, December 31, 20X7
Add: Gross purchases
Deduct: Purchase returns and allowances
Cash discounts on purchases
Net purchases
Add Freight-in
Cost of merchandise acquired
Cost of goods available for sale
Deduct: Inventory, December 31, 20X8
Cost of goods sold
Gross profit

$995
$ 50
4

54
941

$103
$650
$27
6

33
617
50
667
770
185
585
$356

242

7-32

(20 min.)
Sales
Sales returns
Net sales
Cost of goods sold:
Inventory, January 1*
x
Cost of goods purchased:
Purchases
$54,000
Purchase returns
1,000
Net purchases
$53,000
Freight in
400
Cost of goods available for sale
Inventory, January 15
Cost of goods sold, (.76 $68,900)
Gross margin, (.24 $68,900)
* ($52,364 + $41,000 $53,400) = $39, 964
or:
Cost of goods sold (.76 68,900)
Cost of goods purchased
Inventory increase
Ending Balance = Beginning Balance + Increase (or decrease)
$41,000
= Beginning Balance + $1,036
Beginning Balance =

7-33

$71,200
2,300
$68,900
= $39,964

53,400
$93,364
41,000
52,364
$16,536

$52,364
53,400
$ 1,036
$39,964

(5 min.) Amounts are in millions of dollars.

Perpetual
Accounts receivable*
Sales revenue
Cost of goods sold
Merchandise inventory

19
19
17

Periodic
Accounts receivable*
Sales revenue
No entry

17

* Could be a debit to cash if sales were for cash.

243

19
19

7-34

(1015 min.)
Cost of Goods Available = 19,400
(6,000 + 4,200 + 4,400 + 2,300 + 2,500)
LIFO Ending Inventory

= (3,000 @ 2) + (1,000 @ 2.10) = 8,100

FIFO Ending Inventory

Weighted average
Ending inventory

1,000 @ 2.50
1,000 @ 2.30
2,000 @ 2.20
4,000

= 19,400/9,000
4,000 @ 2.16

=
=
=

2,500
2,300
4,400
9,200

= 2.16 per unit

= 8,640*

* With no rounding on the unit cost this would be 8,622.

Cost of Goods Sold Calculation:
LIFO
19,400
(8,100)
11,300

Cost of goods available

Less Ending Inventory
Cost of Goods Sold

FIFO
19,400
(9,200)
10,200

Weighted
Average
19,400
(8,640)
10,760*

* Or 10,778 with no rounding of the unit cost and 8,622 of ending inventory.
7-35

(1015 min.)
This is straightforward. Answers are in Swiss francs.
Aug. 2
Aug. 3
Aug. 7
Aug. 11

Purchases
Accounts payable

350,000
350,000

Freight-in
Cash

15,000

Accounts payable
Purchase returns and allowances

32,000

15,000

Accounts payable
Cash discounts on purchases (.02 318,000)
Cash

244

32,000
318,000
6,360
311,640

7-36

(1015 min.)

1.

Invoice price
Add: Freight-in
Deduct: Purchase allowance
Deduct: Cash discount
Total cost of steel acquired
*2% ($195,000 $9,000)

2.

Purchases *
Accounts payable

$195,000
10,000
(9,000)
(3,720)*
$192,280

195,000
195,000

*The debit is to Purchases under the periodic inventory method specified in this problem.
It would be to Inventory under the perpetual inventory system.
Freight-in
Cash

10,000
10,000

Accounts payable
Purchase returns and allowances
Accounts payable
Cash discounts on purchases
Cash

9,000
9,000
186,000
3,720
182,280

245

7-37

(15 min.)

Amounts are in thousands of dollars.

See Exhibit 7-37 for the balance sheet equation. Although not required, the balance sheet
equation provides a good framework for understanding.
Journal Entries
Perpetual System
a.
b.
c.

Gross purchase:

Inventory
Accounts payable

Returns and allowances:

Accounts payable
Inventory

As goods are sold:

Cost of goods sold

Inventory

d1. and d2.

a.
b.

Gross purchase:

980
70
70
920
920

No entry
Periodic System
Purchases
Accounts payable

Returns and allowances:

Accounts payable
Purchase returns
and allowances

c.

As goods are sold:

No entry

d1.

Transfer to cost of goods sold:

Cost of goods sold

Purchase returns
and allowances
Purchases
Inventory

d2.

980

Recognize ending inventory:

Inventory
Cost of goods sold

246

980
980
70
70

1,020
70
980
110
100
100

EXHIBIT 7-37
Entries are in thousands of dollars.
A

Inventory Purchases
PERPETUAL SYSTEM
Balance, 12/31/X7
a.
Gross purchases
b.
Returns and allowances
c.
As goods are sold

+110
+980
70
920

Closing the accounts at end of period:

d1.
No entry
d2.
No entry
Ending balances, 12/31/X8

+100

PERIODIC SYSTEM
Balance, 12/31/X7
a.
Gross purchases
b.
Returns and allowances
c.
As goods are sold (no entry)
Closing the accounts at
end of period:
d1. Transfer to cost of goods sold
d2.

Recognize ending inventory

Ending balances, 12/31/X8

Purchase
Returns and
Allowances

Accounts
Payable
=
=
=
=

920 [Increase Cost of

Goods Sold]

70

+70

+980

110

980

+100
___
+100

___
0

+1,020
=
=
=

247

____
920

+ 110
+ 980
70

=
0

Retained
Earnings

+ 110
+ 980
70

+110

SE

+1,020

1020 [Increase Cost of

Goods Sold]
+ 100 [Decrease Cost of
Goods Sold]
920

7-38

(10 min.)
This is straightforward.

1.

2.

3.

4.

7-39

Purchases
Accounts payable

900,000
900,000

Accounts payable
Purchase returns and allowances

40,000

Freight-in
Cash

74,000

Accounts payable
Cash
Cash discounts on purchases

40,000

74,000
860,000
842,000
18,000

(10 min.)
The entries could be compounded or consolidated into one entry.
Accounts receivable (or Cash)
Sales

1,200,000
1,200,000

Cost of goods sold

Purchase returns and allowances
Cash discounts on purchases
Purchases
Freight-in
Inventory

987,000
40,000
18,000

Inventory
Cost of goods sold

120,000

900,000
74,000
71,000
120,000

7-40

(1015 min.)
Compound entries could be prepared. (Amounts are in millions.)
Purchases
Accounts payable

140

Accounts receivable
Sales

239

140
239

Sales returns and allowances

Accounts receivable

Accounts payable
Purchase returns and allowances

Freight-in
Cash

7-41

6
14
14

Accounts payable
Cash discounts on purchases
Cash

134

Cash
Cash discounts on sales
Accounts receivable

226
8

Cost of goods sold

Purchase returns and allowances
Cash discounts on purchases
Inventory
Purchases
Freight-in

172
6
1

1
133

234

25
140
14

Inventory
Cost of goods sold

35

Other expenses
Cash (or other accounts)

80

35
80

(5 min.) Amounts are in millions of dollars.

Beginning inventory
Purchases (or production costs)
Cost of goods available
Ending inventory
Cost of goods sold

$ 1,051
64,156
65,207
(776)
$64,431

250

7-42

(1520 min.)

This problem develops familiarity with the gross profit section. The answer, $51,200, is
computed by filling in the gross profit section and solving for the unknown, or: $192,000 (55%
$256,000) = $51,200
Gross sales
Deduct: Sales returns and allowances
Net sales
Cost of goods sold:
Inventory, December 31, 20X7
Gross purchases
Deduct: Purchase returns
and allowances
Cash discounts
on purchases
Net purchases
Inward transportation
Cost of goods acquired
Cost of goods available for sale
Inventory, May 3, 20X8*
Cost of goods sold,
(.55 $256,000)
Gross profit, (.45 $256,000)

$280,000
24,000
$256,000
$38,000
$159,000
$7,000
2,000

(9,000)
150,000
4,000
154,000
192,000
51,200

x=

140,800
$115,200

* Calculated as the difference between cost of goods available for sale, $192,000, and cost of
goods sold, $140,800.
7-43

(15 min.)
Sales
Cost of goods sold:
Inventory, January 1
Purchases
Purchase returns and allowance
Net purchases
Freight-in
Cost of goods available for sale
Inventory, March 9*
Cost of goods sold, (.80 $200,000)
Gross margin, (.20 $200,000)

$200,000
$
$170,000
10,000
$160,000
15,000

70,000

175,000
$245,000
x = 85,000
160,000
$ 40,000

* The answer, $85,000, is obtained by filling in the schedule of cost of goods sold and
solving for the unknown. The estimate of ending inventory is Cost of goods available for sale less
cost of goods sold, or: [$245,000 .80($200,000)] = ($245,000 $160,000) = $85,000.

251

7-44

(1015 min.)
Beginning inventory
Purchases
Cost of goods available for sale
Less estimated cost of goods sold:
(.75 $300,000)
Estimated ending inventory

$ 55,000
210,000
$265,000
225,000
$ 40,000

The difference between $40,000 and the actual amount of inventory remaining determined by a
physical count is an estimate of the amount missing.
7-45

(1015 min.)

1 & 2. To calculate the effect use the following approach:

20X5
Beginning inventory
+ Purchases
Goods available
Ending inventory
Cost-of-goods sold

OK
OK
OK
Too low
Too high

20X6

$20,000
$20,000

Too low
OK
Too low
OK
Too low

$20,000
$20,000
$20,000

Cost-of-goods sold is too high by $20,000 in 20X5 so taxable income will be too low by
$20,000. Taxes will be too low by $8,000 so net income and retained earnings will be too low by
$12,000. Taxable income for 20X6 will be overstated by $20,000 and taxes will be $8,000 too
high. Net income in 20X6 will be too high by $12,000 and retained earnings will be correct again
at December 31, 20X6.

252

7-46

(1015 min.)

1.

Inventory turnover

= Cost of goods sold* Average inventory

= $1,180,000 $1,000,000
= 1.18

*Cost of goods sold = ($2,500,000 $1,320,000) = $1,180,000

2.

The gross profit would increase from $1,320,000 to $1,500,000, so a change in pricing
strategy would be desirable for Burlingame Gems. The current 20X3 data follow:
Inventory turnover
Gross profit percentage:
$1,320,000 $2,500,000
This percentage is not unusual.

1.18
52.8%

If prices are cut 10 percent in 20X4 without affecting inventory turnover, new sales would
be (.9 $2,500,000) = $2,250,000. Cost of goods sold on those sales would still be
$1,180,000. Therefore, Ms. Scott would be reducing her gross profit from $1,320,000 to
($2,250,000 $1,180,000) = $1,070,000. The loss in gross profit of $250,000 is exactly
equal to the dollar decline in sales. The new gross profit percentage is 47.6% ($1,070,000
$2,250,000).
However, an increase in inventory turnover to 1.5 with stable inventory levels implies
higher sales at the lower gross profit percentage:
Sales, $2,250,000 ($1,500,000 $1,180,000)*
Cost of goods sold, ($1,000,000 1.5)**
Gross profit

$2,860,170
1,500,000
$1,360,170

* This calculation could also use the ratio of the turnover ratios: $2,250 (1.5 1.18)

**Remember that inventory turnover is computed as (Cost of goods sold Average

inventory). Average inventory is assumed to be unchanged at $1,000,000. With an
increase in inventory turnover to 1.5, cost of goods sold will be (Average inventory
inventory turnover) or ($1,000,000 x 1.5 = $1,500,000).
Gross profit would be $1,360,170 - $1,320,000 = $40,170 above the 20X3 level.

253

7-47

(1520 min.)

1.

LIFO Method:
Inventory shows:
Costs:

1,200 tons on hand at July 31.

1,000 tons @ $ 9.00
200 tons @ $10.00

$ 9,000
2,000
$11,000

July 31 inventory cost

FIFO Method:
Inventory shows:
Costs:

1,200 tons on hand at July 31.

800 tons @ $12.00
400 tons @ $11.00

$ 9,600
4,400
$14,000

July 31 inventory cost

2.

Purchases:
5,000 tons @ $10
1,000 tons @ $11
800 tons @ $12
Total purchases
Beginning inventory:
1,000 tons @ $ 9

$50,000
11,000
9,600
$70,600
9,000

Cost of goods available for sale

Less ending inventory
Cost of goods sold

$79,600

Sales
Cost of goods sold
Gross profit

254

LIFO
$ 79,600
(11,000)
$ 68,600

FIFO
$ 79,600
(14,000)
$ 65,600

$102,000
68,600
$ 33,400

$102,000
65,600
$ 36,400

7-48

(510 min.)

U. S. GAAP: The inventory would be written down from $200,000 to $185,000 on

December 31, 20X1. The new $185,000 valuation is whats left of the original $200,000 cost.
In other words, the $185,000 is the unexpired cost and may be thought of as the new cost of the
inventory for future accounting purposes. Thus, because subsequent replacement values exceed
the $185,000 cost, and write-ups above cost are not acceptable accounting practice, the
valuation remains at $185,000 until it is written down to $180,000 on the following December 31,
20X2.
IFRS: The inventory would be written down from $200,000 to $195,000 on December 1,
20X1. It would be written back up to $200,000 on April 30, 20X2. It would remain at $200,000
until December 31, 20X2, when it would be written down to $190,000.
7-49

(1015 min.) Amounts are in millions of dollars.

The cost of inventory acquired during the year ending August 28, 2011, can be calculated
as follows.
Beginning Inventory
Purchases
Cost of goods available
Ending inventory
Cost of merchandise sold
Y
X

$ 5,638
X
Y
(6,638)
$77,739

=
=

78,739
84,377

= $77,739 + $ 6,638 = $84,377

= $84,377 $5,638 = $78,739

Costco explicitly discussed two issues. Its costs increased and it was unable to pass the
increases on to its customers. Also, its mix of sales changed so that a higher percentage of sales
came from lower margin products, in this case, gasoline. Other explanations might include an
increase in shrinkage or an actual decrease in sales prices due to competition.
7-50

(10 min.) Dollar amounts are in millions.

2012: ($13,909 $8,939) $13,909 = 35.73%
2011: ($13,864 $8,939) $13,864 = 35.52%
2010: ($13,568 $8,790) $13,568 = 35.22%

The gross profit percentage was relatively steady over these three years, with a small
increase in each year. But notice that these increases are on a level of sales where the absolute
numbers are large. On almost $14 billion of sales the approximately 0.5% increase translates to
$70 million.
Although not in the problem, it is interesting to note that the gross profit percentage
ranged from 27% to 31% for the ten years from 1994 to 2003. More recently from 2007 to 2009
it ranged from 33.81% to 34.85%. Looked at over almost 20 years the change is substantial.
255

7-51

(1015 min.)

1.

PARR BUILDING SUPPLY

Statement of Gross Profit
For the Year Ended December 31, 20X9
Sales
Cost of goods sold:
Inventory, beginning
Add net purchases
Cost of goods available for sale
Deduct ending inventory
Cost of goods sold
Gross profit

2.

Inventory turnover

7-52

(3040 min.)

=
=
=
=

$1,200,000
$ 240,000
1,035,000
$1,275,000
(275,000)
1,000,000
$ 200,000

Cost of goods sold Average inventory

$1,000,000 [1/2 ($240,000 + $275,000)]
$1,000,000 $257,500
3.88 times

The detailed income statement is in the accompanying exhibit on the following page. Note
the classification of operating expenses into a selling category and a general and administrative
category. The list of accounts in the problem contained one item that belongs in a balance sheet
rather than an income statement, the Allowance for Bad Debts (an offset to Accounts Receivable).
The delivery expenses and the bad debts expense are shown under selling expenses. Some
accountants prefer to show the bad debts expense as an offset to gross sales or as administrative
expenses.

256

7-52

(cont.)

MORLAN BATHROOM SUPPLY COMPANY

Income Statement
For the Year Ended December 31, 20X5
(In Thousands)
Revenues:
Gross sales
Deduct: Sales returns and allowances
Cash discounts on sales
Net sales
Cost of goods sold:
Inventory, December 31, 20X4
Add purchases
Less: Purchase returns and allowances
$40
Cash discounts on purchases
15
Net purchases
Add Freight in
Cost of merchandise acquired
Cost of goods available for sale
Deduct: Inventory, December 31, 20X5
Cost of goods sold
Gross profit from sales
Operating expenses:
Selling expenses:
Sales salaries and commissions
Rent expense, selling space
Advertising expense
Depreciation expense, trucks and store fixtures
Bad debts expense
Delivery expense
Total selling expenses
General and administrative expenses:
Office salaries
Rent expense, office space
Depreciation expense, office equipment
Office supplies used
Miscellaneous expenses
Total general and administrative expenses
Total operating expenses
Income before income tax
Income tax expense
257

$1,066
$ 50
16

66
$1,000

$200
$700
55
$645
55
700
$900
300
$

600
400

$160
50
45
29
8
20
$312
46
10
3
6
13
78
390
$ 10
4

Net income

258

7-53

(1015 min.)

Under the FIFO cost-flow assumption, the periodic and perpetual procedures give
identical results. The ending inventory will be valued on the basis of the last purchases during the
period.
Units

Beginning Inventory
Purchases

100
290

500
2,050

Goods available
Units sold

390
255

2,550
1,505**

Units in ending inventory

135

1,045*

* 135 units remain in ending inventory

100 will be valued at the $8 cost from the October 21 purchase and the remaining 35
will be valued at the $7 cost from the May 9 purchase
100 $8
35 $7

=
=

800
245
$1,045 Ending inventory

** Reconciliation:
255 Units:

Cost of Goods Sold:

100 $5
=
$ 500
80 $6
=
480
75 $7
=
525
$1,505

259

7-54

(3035 min.)

1.

Gross profit percentage = $2,400,000 $6,000,000 = 40%

Inventory turnover

= $3,600,000 [($1,300,000 + $1,100,000) 2]

= 3 times

2.

Inventory turnover = $3,600,000 $1,000,000 = 3.6 times, a 20% increase in turnover.

3.

With a lower average inventory and constant inventory turnover, cost of sales must fall.
Total cost of goods sold = ($1,000,000 3) = $3,000,000. To achieve a gross profit of
$2,400,000, total sales must be ($3,000,000 + $2,400,000), or $5,400,000. The gross
profit percentage must be ($2,400,000 $5,400,000) = 44%. Requirements 2 and 3 show
that if inventory levels are reduced, you must increase either inventory turnover or profit
margins to maintain profitability.

4.

Summary (computations are shown below):

Sales
Cost of goods sold
Gross profit
a.

Given Year
$6,000,000
3,600,000
$2,400,000

Succeeding Year
4a
4b
$5,785,714
$6,187,500
3,240,000
3,960,000
$2,545,714
$2,227,500

New gross profit percentage, [40% + .10(40%)] = 44%

New inventory turnover, [3 .10(3)] = 2.7
New cost of goods sold, ($1,200,000 2.7) = $3,240,000
New sales
= $3,240,000 (1 .44)
= $3,240,000 .56
= $5,785,714

Note that this is a more profitable alternative, assuming that the gross profit percentage
and the inventory turnover can be achieved. In contrast, alternative 4b is less attractive
than the original 40% gross profit and turnover of 3.
b.

5.

New gross profit percentage, [40% .10(40%)] = 36%

New inventory turnover, [3 + .10(3)] = 3.3
New cost of goods sold, ($1,200,000 3.3) = $3,960,000
New sales
= $3,960,000 (1 .36)
= $3,960,000 .64
= $6,187,500

Retailers find these ratios (and variations thereof) helpful for performing what if analysis
for a variety of operating decisions. An example is quantifying the options facing
management regarding what and how much inventory to carry and what pricing policies to
follow. You may want to stress that this analysis ignores one benefit of higher inventory
turnoverthe firm reduces its investment in inventory and reduces storage and display
requirements.
260

7-55

(2535 min)
SEARS HOLDINGS CORPORATION
Income Statement
For the Year Ended January 28, 2012
(In Millions)
Revenue
Cost of Sales:
Beginning inventory
Plus purchases
Goods available
Less ending inventory
Gross margin

$41,567
$ 8,951
30,422
39,373
8,407

Operating Expenses:
Selling and administrative
Depreciation and amortization
Other
Operating income
Other income (expenses):
Other income
Interest expense
Income before income taxes
Income tax expense
Net earnings from continuing operations

$10,664
853
585
$

39
(289)

30,966
10,601

12,102
(1,501)
(250)
(1,751)
(1,369)
$ (3,120)

Deserving of discussion is the fact that there was income tax expense recognized despite the
existence of a significant loss. Usually when a loss occurs from operating income a tax benefit is
generated that reflects the ability to carry the loss forward to shield income in future years. In this
instance, the size of the loss raises questions about the recoverability of the tax loss carryforwards in the future and doubts about recognition of previously recognized deferred tax assets.
As a result a valuation allowance of $2.3 billion was shown at the end of the year and gave rise to
the recognition of tax expense. This topic will be covered in Chapter 9, but not in extensive
detail. Our belief is that students need to see occasional examples of the more complex terrain
that lies ahead. Taxes are a major area of complexity

261

7-56

(2030 min.)

1.

CONTRACTOR SUPPLY CO.

Comparison of Inventory Methods
Statement of Gross Profit of Kemtone Cooktops
For the Year Ended December 31, 20X8
(In Dollars)
FIFO

Weighted
Average

LIFO

Sales, 260 units

26,200
26,200
Deduct cost of goods sold:
Inventory, December 31,
20X7, 110 @ $50
5,500
5,500
Purchases, 300 units
21,200
21,200
Cost of goods available for
sale, 410 units
26,700
26,700
Deduct: Inventory, December
31, 20X8, 150 units:
100 @ $80
8,000
50 @ $70
3,500
11,500
110 @ $50
5,500
40 @ $60*
2,400
7,900
150 @ ($26,700 410),
150 @ $65.12

26,200
5,500
21,200
26,700

9,768
Cost of goods sold,
260 units
Gross profit

15,200
11,000

18,800
7,400

16,932
9,268

* This is a periodic LIFO. Students are using perpetual LIFO if they answer 20 @ $60 plus 20 @
$80 = $2,800.
2.

Income taxes would be lower by [.40 ($11,000 $7,400)] = $1,440 if the company used
LIFO rather than FIFO. The income tax rate is assumed to be identical at all levels of
taxable income. Some students will wonder why no information is given regarding other
expenses and net income. Such information is unnecessary because other expenses,
whatever their amounts, will be common among all inventory methods. Thus gross profits
provide sufficient information to measure the differences in income taxes among various
inventory methods.

262

7-57

(1520 min.)

There would be no effect on gross profit, net income, or income taxes under FIFO,
although the balance sheet would show ending inventory as $8,000 higher. The income statement
would show purchases and ending inventory as higher by $8,000, so the net effect on cost of
goods sold would be zero.
LIFO would show a lower gross profit, $6,000, as compared with $7,400, a decrease of
$1,400. Hence, the impact of the late purchase on income taxes would be a savings of 40% of
$1,400 = $560.
The following tabulation compares the results under LIFO (in dollars):
Without Late Purchase
Sales, 250 Units
Deduct: Cost of goods sold:
Inventory, December 31, 20X7,
110 @ $50
Purchases, 300 units at various
costs
100 units @ $80
Cost of goods available for sale
Deduct: Inventory, December
31, 20X8:
First layer (pool) 110 @ $50
Second layer (pool) 40 @ $60
Second layer (pool) 80 @ $60
Third layer (pool) 60 @ $70
Cost of goods sold, 260 units
Gross profits
Income taxes @ 40%

With Late Purchase

26,200

5,500
2,400

26,200

5,500

5,500

21,200

26,700

21,200
8,000
34,700
5,500

7,900
4,800
4,200

14,500

18,800
7,400
2,960

20,200
6,000
2,400

Although purchases are $8,000 higher than before, the new LIFO ending inventory is only
($14,500 - $7,900) = $6,600 higher. The $1,400 difference in gross profit is explained by the fact
that the late purchase resulted in changes to both ending inventory and cost of goods sold. LIFO
cost of goods sold is $1,400 higher ($20,200 $18,800).
To see this from another angle, compare layers. Without the late purchase, the second
layer had 40 units @ $60. With the late purchase:
Late purchase released as expense, 100 @ $80
Second layer is 40 units higher @ $60
Third layer is 60 units @ $70
Amount held as ending inventory that
would otherwise have been released as
expense in the form of cost of goods sold
Difference in cost of goods sold
263

$8,000
= $2,400
= 4,200
6,600
$1,400

7- 58 (15 min.)
1.

LIFO:

2.

Replacement cost: 120 units @ $12 = $1,440

LIFO is lower than replacement cost. Therefore, no inventory write-down takes place,
and the balance sheet shows $1,240.

3.

FIFO:

4.

Replacement cost is $1,440 (see requirement 2). Because replacement cost is lower than
FIFO, the balance sheet should include the lower amount, $1,440. Most companies would
treat the $100 inventory write-down as an increase in cost of sales.

7-59

(1015 min.)

1.

100 units @ $10

20 units @ $12

$1,000
240
$1,240

20 units @ $12
100 units @ $13

$ 240
1,300
$1,540

O is used for overstated, U for understated, and N for not affected.

(In Thousands)
20X1
20X2
N
O
$20
O
$20
N
U
20
O
20
O
20
U
20
O
20
U
20
O
8
U
8
O
12
U
12

Beginning inventory*
Ending inventory*
Cost of goods sold
Gross profit
Income before income taxes
Income tax expense
Net income

*The ending inventory for 20X1 becomes the beginning inventory for 20X2.
2.

Retained earnings would be overstated by $12,000 at the end of the first year. However,
the error would be offset in the second year, assuming no change in the 40% income tax
rate. Therefore, retained earnings would be correct at the end of the second year.

264

7-60

(2030 min.)

1.

See Exhibit 7-60 on the following page.

2.

Purchases at $12 per unit reflect rising costs and therefore LIFO yields lower gross
margins. Purchases at $8 per unit reflect falling costs and therefore LIFO yields higher
gross margins.

3-4.

Given the structure of the numbers in this problem, when prices are rising to $12 the
difference in taxable income between LIFO and FIFO is $20,000 and when prices are
falling it is also $20,000. The calculations can be done by comparing either the difference
in Cost of Goods Sold or in Gross Margin.
In 3, LIFO results in more cash by the difference in income tax effects. LIFO results in a
lower cash outflow of [.40 ($104,000 $84,000)] = $8,000.
In 4, FIFO results in more cash when inventory prices are falling. Why? Because income
tax cash outflow would be more under LIFO by [.40 ($132,000 $112,000)] = $8,000.

7-61

(20 min.)

1.
Units
Sales
Cost of goods sold:
Inventory, December 31, 20X7
Purchases
Cost of goods available for sale
Inventory, December 31, 20X8
Cost of goods sold
Gross margin or gross profit

2.

14,000 @ 6
12,000 @ 7
26,000

=
=

84,000
84,000
168,000

**

26,000 @ 8

208,000

LIFO

FIFO

40,000

444,000

444,000

14,000
52,000
66,000
26,000
40,000

84,000
394,000
478,000
168,000*
310,000
134,000

84,000
394,000
478,000
208,000**
270,000
174,000

Gross margin is higher under FIFO. However, cash will be higher under LIFO by [.40
(174,000 134,000)] = (.40 40,000) = 16,000. Cash payments for inventory and
cash receipts from sales are unaffected by the cost flow assumption. Only the effect on tax
obligations affects cash flow.

265

EXHIBIT 7-60
Purchases @ $12 Unit
Requirement a
FIFO
LIFO
Sales, 12,000 @ $19
Deduct cost of goods sold:
Inventory, December 31, 20X1, 10,000 @ $10
Purchases: 13,000 @ $12 and $8, respectively
Cost of goods available for sale
Deduct: Inventory, December 31, 20X2,
11,000 units:
11,000 @ $12 =
or
10,000 @ $10 = $100,000
1,000 @ $12 =
12,000
or
11,000 @ $ 8 =
or
10,000 @ $10 = $100,000
1,000 @ $ 8 =
8,000
Cost of goods sold
Gross margin

Purchases @ $8 Unit
Requirement b
FIFO
LIFO

$228,000

$228,000

$228,000

$228,000

100,000
156,000
256,000

100,000
156,000
256,000

100,000
104,000
204,000

100,000
104,000
204,000

132,000
112,000
88,000

124,000
$104,000

266

144,000
$ 84,000

116,000
$112,000

108,000
96,000
$132,000

7-62

(35 min.)

1.

(Dollars in Thousands)
Lastin Company
(LIFO)

Sales
Deduct cost of goods sold:
Beginning inventory:
11,000 tons @ $50
Purchases:
30,000 tons @ $60
20,000 tons @ $70
Cost of goods
available for sale
Ending inventory:
11,000 tons @ $50
4,000 tons @ $60
Cost of goods sold
Gross profit
Other expenses
Income before income taxes
Income taxes at 40%
Net income
2.

Firstin Company
(FIFO)

$4,600

$1,800
1,400

$4,600

$ 550

$ 550

3,200

3,200

$3,750

$3,750

$ 550
240

15,000
@ $70

790
2,960
$1,640
600
$1,040
416
$ 624

1,050
2,700
$1,900
600
$1,300
520
$ 780

Note first that the underlying events are identical, but the inventory method chosen
produces radically different results. When prices are rising, and if she had a choice, the
manager would choose the method that is most harmonious with her objectives. Clearly
the company is better off financially under the LIFO method due to lower taxes, even
though reported earnings are less. LIFO saved $104 thousand in income taxes:
Cash receipts:
Sales
Cash disbursements:
Purchases
Other expenses
Income taxes
Total disbursements
Net increase in cash

$3,200
600

LIFO

FIFO

$4,600

$4,600

$3,800
416
$4,216
$ 384

$3,800
520
$4,320
$ 280

On the other hand, reported net income is dramatically better under FIFO, $780 versus
$624. In times of rising prices and stable or increasing inventory levels, the general guide
is that LIFO saves income taxes and results in a better cash position; nevertheless, FIFO
shows the higher reported net income.

267

7-63

(30 min.)

1.
20X1

20X2

20X3

20X4

20X5

Total

FIFO:
Sales
Cost of goods sold
Income before taxes
Income taxes @ 40%
Net income

$5,000
1,000
4,000
1,600
$2,400

$5,000
2,000
3,000
1,200
$1,800

$5,000
2,000
3,000
1,200
$1,800

$5,000
2,500
2,500
1,000
$1,500

$15,000
9,500
5,500
2,200
$ 3,300

$35,000
17,000
18,000
7,200
$10,800

LIFO:
Sales
Cost of goods sold
Income before taxes
Income taxes @ 40%
Net income

$5,000
2,000
3,000
1,200
$1,800

$5,000
2,500
2,500
1,000
$1,500

$5,000
3,000
2,000
800
$1,200

$5,000
3,500
1,500
600
$ 900

$15,000
6,000
9,000
3,600
$ 5,400

$35,000
17,000
18,000
7,200
$10,800

2.

LIFO is most advantageous because it defers tax payments. This provides additional cash
and reduces the need for borrowing. One way to think about the benefit is to think of the
interest saved each year. For example, assume that if higher taxes were paid, that amount
would be borrowed at an interest rate of 10%.

FIFO tax
LIFO tax
Annual cash benefit /(loss)
Cumulative cash benefit
Interest saved @ 10%

20X1

20X2

20X3

20X4

$1,600
1,200
$ 400
$ 400
$ 40

$1,200
1,000
$ 200
$ 600
$ 60

$1,200
800
$ 400
$1,000
$ 100

$1,000
600
$ 400
$1,400
$ 140

20X5

Total

$2,200
$7,200
3,600
7,200
$(1,400) $
0

$ 340

This analysis does not consider the time value of money in that interest savings are simply
added together, but it does provide a vivid illustration of the concept.

268

7-64

(3040 min.)

1, 2.
Sales *
Less cost of goods sold:
Purchase cost
Less ending inventory:
FIFO: 4,000 @ $15
LIFO:
1,000 @ $9 = $ 9,000
1,000 @ $10 = 10,000
1,000 @ $11 = 11,000
1,000 @ $13 = 13,000
Cost of goods sold
Other expenses
Total deductions
Income before taxes
Income taxes @ 40%
Net income
$ 16,200

FIFO
1(a)
2(a)
$120,000
$100,000

LIFO
1(b)
2(b)
$120,000
$100,000

$117,000

$117,000

60,000

$ 57,000
31,000
$ 88,000
$ 32,000
$ 12,800
$ 19,200

$60,000
30,000
$90,000
$10,000
$ 4,000
$ 6,000

43,000
$ 74,000
31,000
$105,000
$ 15,000
$ 6,000

$ 43,000
30,000
$ 73,000
$ 27,000
$ 10,800

* Sales are 5,000 units in year 1; 4,000 in year 2.

3.
Sales
Less cost of goods sold:
Purchase cost**
Other expenses
Total deductions
Income before taxes
Income taxes @ 40%
Net income

1(a)
$120,000

FIFO
2(a)
$100,000

LIFO
1(b)
2(b)
$120,000
$100,000

$ 57,000
31,000
$ 88,000
$ 32,000
$ 12,800
$ 19,200

$ 60,000
30,000
$ 90,000
$ 10,000
$ 4,000
$ 6,000

$ 57,000
31,000
$ 88,000
$ 32,000
$ 12,800
$ 19,200

$ 60,000
30,000
$ 90,000
$ 10,000
$ 4,000
$ 6,000

The timing of purchases does not affect FIFO income but affects LIFO income. LIFO cost
of goods sold in year 1 declined from $74,000 to $57,000 as a result of the delay in purchase.
Managers can directly influence LIFO net income by choices to replenish inventory.
**In this example all purchases are sold each year and no inventories accumulate. Therefore,
FIFO and LIFO give identical results.

269

7-65

(2030 min.)

The major point here is to demonstrate that changes in LIFO reserves can be used as a
shortcut measure of the differences in cost of goods sold under FIFO and LIFO. (All amounts are
in dollars.)
1.

(1)
FIFO

(2)
LIFO

Beginning inventory, 2 @ $20, 2 @ $12

Purchases: 3 @ $24 + 3 @ $28
Cost of goods available for sale
Ending inventory, 2 @ $28, 2 @ $12
Cost of goods sold

40
156
196
56
140

24
156
180
24
156

Beginning inventory
Purchases
Available for sale
Ending inventory
Cost of goods sold

40
156
196
0
196

24
156
180
0
180

LIFO
Reserve
(1) (2)
16
16
32
(16)

2.

3.

16
16
0
16

From Part 1, the beginning LIFO Reserve is 16, the difference between FIFO inventory of
40 and LIFO inventory of 24. At year end the LIFO Reserve is 32, an increase of 16.
This 16 is exactly the difference between FIFO cost of goods sold of 140 and LIFO cost
of goods sold of 156. If prices are rising, cost of goods sold includes more of these recent
higher costs under LIFO than under FIFO. Hence, if physical quantities are held constant,
the LIFO reserve will rise by the difference between the LIFO and FIFO cost of goods
sold. Why? Because old LIFO unit costs will still be held in ending inventory, whereas
recent higher unit costs will apply to the ending FIFO inventory.
If the older LIFO layers are liquidated, the LIFO cost of goods sold becomes less than
FIFO cost of goods sold. As 2 demonstrates, the total liquidation of inventories will result
in FIFO cost of goods sold exceeding LIFO cost of goods sold by the amount of the LIFO
reserve at the start of the year.

270

7-66

(1520 min.)

1.

O is used for overstated; U is used for understated:

20X3
Correct
Correct
U $5
O 5
U 5
U 5
U 2
U 3

Beginning inventory*
Cost of goods available
Ending inventory*
Cost of goods sold
Gross margin
Income before income taxes
Income tax expense
Net income

(In Millions)
20X2
O $10
O 10
Correct
O 10
U 10
U 10
U
4
U
6

20X1
Correct
Correct
O $10
U 10
O 10
O 10
O
4
O
6

*The ending inventory for a given year becomes the beginning inventory for the following
year.
2.

Retained earnings would be overstated by $6 million at the end of 20X1. However, the
error would be offset in the second year. Therefore, retained earnings would be correct at
the end of 20X2. Retained earnings is understated by $3 million at the end of 20X3.
Given that the asset, inventory, is understated by $5 million, there must also be $5 million
in understatements on the L + OE side of the accounting equation. In this case the
additional $2 million is in taxes payable.

7-67

(3040 min.)

1.

See Exhibit 7-67 on the following page.

2.

a.

Income before income taxes will be lower under LIFO than under FIFO:
($149,000 $124,000) = $25,000. The income tax will be lower by (.40
$25,000) = $10,000.

b.

Income before income taxes will be lower under LIFO than under weightedaverage: ($135,950 $124,000) = $11,950. The income tax will be lower by (.40
$11,950) = $4,780.

271

EXHIBIT 7-67
FIFO
Net revenue from sales
(150 @ $900) + (160 @ $1,000)
Deduct cost of products sold:
Inventory, January 28, 2011,
100 @ $400
Purchases (200 @ $500) + (160 @ $600)
Cost of goods available for sale, 460 units
Deduct: Inventory, February 3, 2012, 150 units:
150 @ $600
or
100 @ $400 = $40,000
50 @ $500 = 25,000
or
150 @ ($236,000 460) or 150 @ $513
or
50 @ $400 = $20,000
50 @ $500 = 25,000
50 @ $600 = 30,000
Cost of goods sold
Gross margin

LIFO

Weighted
Average

Specific
Identification

$295,000

$295,000

$295,000

$295,000

40,000
196,000
236,000

40,000
196,000
236,000

40,000
196,000
236,000

40,000
196,000
236,000

90,000
65,000
76,950

146,000
$149,000

272

171,000
$124,000

159,050
$135,950

75,000
161,000
$134,000

7-68

(2030 min.) This problem explores the effects of LIFO layers.

There would be no effect on gross margin, income taxes, or net income under FIFO. The
balance sheet would show a higher inventory by $35,000. A detailed income statement would
show both purchases and ending inventory as higher by $35,000, so the net effect on cost of
goods sold would be zero.
LIFO would show a lower gross margin, $112,000, as compared with $124,000, a
decrease of $12,000. Hence, the impact of the late purchase would be a savings of income taxes
of 35% of $12,000 = $4,200. For details, see the following tabulation.

Net revenues from sales as before

$295,000
Deduct cost of goods sold:
Inventory, January 28, 2011,
100 @ $400
Purchases, 360 units, as before,
and 410 units
Cost of goods available for sale
Ending inventory:
First layer 100 @ $400 plus
second layer 50 @ $500
First layer 100 @ $400 plus
second layer 100 @ $500
Cost of goods sold
Gross margin
*360 units, as before
50 units @ $700

Without Late
Purchase
$295,000

With Late
Purchase

$ 40,000

$ 40,000

196,000
$236,000

231,000*
$271,000

65,000
90,000
171,000
$124,000

181,000
$114,000

$196,000
35,000
$231,000

Although purchases are $35,000 higher than before, the new LIFO ending inventory is
only ($90,000 $65,000) = $25,000 higher. The cost of sales is ($181,000 $171,000) =
$10,000 higher.
To see this another way, compare the ending inventories:
Late purchase added to cost of goods available for sale: 50 $700
Deduct 50-unit increase in ending inventory:
Second layer is (100 50) = 50 units higher @ $500
Cost of sales is higher by: [50 ($700 $500)]

$35,000

=
=

25,000
$10,000

Because cost of sales is higher by $10,000, taxes are lower by (.40 $10,000) = $4,000.
7-69

(3040 min.)
See Exhibit 7-69 on the following page.
273

EXHIBIT 7-69
1.

TEXAS INSTRUMENTS
Semiconductor Unit
Comparison of Inventory Methods
Income Statement
For the Year Ended December 31, 2011

FIFO
LIFO
Weighted Average
Net sales, 190 units
$2,260
$2,260
$2,260
Deduct cost of sales:
Beginning inventory, 80 @ $5
$ 400
$ 400
$ 400
Purchases, 220 units*
1,580
1,580
1,580
Available for sale, 300 units**
$1,980
$1,980
$1,980
Ending inventory, 110 units:
90 @ $8
$720
20 @ $7
140
860
or
80 @ $5
$400
30 @ $6
180
580
or
110 @ ($1,980 300), or
110 @ $6.60
726
Cost of sales, 190units
1,120
1,400
_1,254
Gross margin
$1,140
$ 860
$1,006
Other expenses
600
600
600
Pretax income
$ 540
$ 260
$ 406
Income taxes at 40%
216
104
162
Net income
$ 324
$ 156
$ 244
Values for taxes and net income for weighted average are rounded to nearest dollar
* Always equal across all three methods.
** These amounts will not be equal across the three methods usually, because the beginning inventories will generally be different.
The amounts are equal here only because beginning inventories are assumed to be equal.
274

Income taxes would be lower under LIFO by [.40 ($540 $260)] = (.40 $280) = $112.
This is the tax rate times the difference in pretax income. Or from the table, ($216 $104)
= $112.

2.

3.
Sales
Cost of goods available for sale
Ending inventory
(90 @ $8) + (20 @ $7)
(60 @ $5) + (50 @ $8)
Cost of sales
Gross Margin

a
$2,260
$1,980

b
$2,260
$1,980

860
$1,120
$1,140

700
$1,280
$ 980

The specific identifications are often cumbersome, although technology has reduced the
cost of using them. They obviously affect income and income taxes. This method permits
the most latitude in determining income for a given period.
7-70

(1520 min.)

There would be no effect on gross margin, income before income taxes, or income taxes
under FIFO. The balance sheet would show a higher inventory by $400. A detailed income
statement would show both purchases and ending inventory as higher by $400, so the net effect
on cost of goods sold would be zero.
LIFO would show a lower income before income taxes, $260, as compared with $190, a
decrease of $70. Hence, the impact of the late purchase would be a savings of income taxes of
40% of $70 = $28. For details, see the accompanying tabulation.

7-70

(cont.)

The following tabulation compares the results under LIFO:

Without Late
Purchase
Net sales, 190 units
Deduct cost of sales:
Beginning inventory 80 @ $5
Purchases, 220 units
and 270 units
Available for sale
Ending inventory:
First layer (pool) 80 @ $5
Second layer (pool)
30 @ $6
First layer (pool) 80 @ $5
Second layer (pool)
50 @ $6
Third layer (pool) 30 @ $7
Cost of sales
Gross margin
Other expenses
Pretax income
Income taxes
Net income
*Purchases for 220 units
New purchases, 50 units

With Late
Purchase

$2,260

$2,260

$ 400

$ 400

1,580
$1,980

1,980*
$2,380

$400
180

580
$400
300
210
1,400
860
600
260
104
$ 156

910
1,470
790
600
190
76
$ 114

$1,580
400
$1,980

Although purchases are $400 higher than before, the new LIFO ending inventory is only ($910
$580) = $330 higher. The cost of sales is ($1,400 $1,470) = $70 higher.
To see this from another angle, compare the ending inventories:
Late purchase added to cost of goods available for sale
Deduct 50-unit increase in ending inventory:
Second layer is (50 30) = 20 units higher @ $6
Third layer is (30 0) = 30 units higher @ $7
Cost of sales is higher by

277

$400
= $120
= 210

330
$ 70

7-71

(2030 min.)
This is a classic problem. Knowledge of discounted cash flow is not necessary.

Because money today is more valuable than money some time in the future, it is desirable
to take a tax deduction earlier rather than later. Moreover, if prices rise, LIFO will generate
earlier tax deductions than FIFO. By switching from LIFO to FIFO, Chrysler deliberately boosted
its tax bills by $53 million in exchange for real or imagined benefits in terms of its credit rating and
the attractiveness of its common stock as compared with its competitors in the auto industry.
Was this a wise decision? Many critics thought it harmed rather than helped stockholders
because the supposed benefits were illusory. For example, these critics maintain that mounting
evidence about efficient stock markets shows that the investment community is not fooled by
whether a company is on LIFO or FIFOthat its stock price will be unaffected. An American
Accounting Association committee (Accounting Review, Supplement to Vol. XLVIII, p. 248)
commented: If the capital markets are efficient in the semi-strong form, this change was totally
unnecessary and, from the point of view of Chryslers shareholders, constitutes a waste of
resources.
In sum, Chrysler gave up badly needed cash in the form of higher income taxes in
exchange for a higher current ratio (FIFO inventory would be much higher than LIFO inventory)
and higher reported net income. In light of Chryslers deteriorating cash position in the late
1970s, Chryslers tradeoff was unwise.
7-72

(4060 min.)

1.

LIFO
Buy
Sales: 1,000,000 @ $5
Cost of goods sold (LIFO basis):
300,000 units, @ $3
=
700,000 units, @ $2
=
or
400,000 units, @ $4
=
300,000 units, @ $3
=
300,000 units, @ $2
=
Gross profit
Other expenses
Income before taxes
Income taxes
Net income
Earnings per share
(a)
(b)

Do Not Buy(a)
$5,000,000
$ 900,000
1,400,000

2,300,000

$1,600,000
900,000
600,000
$2,700,000
1,400,000
$1,300,000
520,000
$ 780,000
$
7.80

Ending inventory, 200,000 units @ $2

Ending inventory, 600,000 units @ $2
278

More Units(b)
$5,000,000

$ 400,000
$1,200,000

3,100,000
$1,900,000
1,400,000
$ 500,000
200,000
$ 300,000
$
3.00

7-72

(cont.)

2.

FIFO
Buy
Sales: 1,000,000 @ $5
Cost of goods sold (FIFO basis):
900,000 units, @ $2
=
100,000 units, @ $3
=
Gross profit
Other expenses
Income before taxes
Income taxes
Net income
Earnings per share
(c)
(d)

3.

$1,800,000
300,000

Ending inventory, 200,000 units @ $3

Ending inventory, 400,000 units @ $4
200,000 units @ $3
Total

(c)
Do Not Buy
$5,000,000

(d)
More Units
$5,000,000

2,100,000
$2,900,000
1,400,000
$1,500,000
600,000
$ 900,000
$
9.00

2,100,000
$2,900,000
1,400,000
$1,500,000
600,000
$ 900,000
$
9.00

$ 600,000
1,600,000
600,000
$2,200,000

Consider this question from a strict financial management standpointignoring earnings per
share. When prices are rising, it may be advantageoussubject to prudent restraint as to
maximum and minimum inventory levelsto buy unusually heavy amounts of inventory at
year-end, particularly if income tax rates are likely to fall. Under LIFO, the current year tax
savings would be a handsome $320,000. This is at least a deferral of the tax effect. The
effects on later years taxes will depend on inventory levels, prices, and tax rates.
Tax savings can be generated because LIFO permits management to influence immediate
net income by its purchasing decisions. In contrast, FIFO results would be unaffected by
this decision.
However, if management buys the 400,000 units and uses LIFO, the first year earnings per
share would be only $3.00. Note too that LIFO will show less earnings per share than
FIFO ($7.80 as compared to $9.00), even if the 400,000 units are not purchased. Such
results may cause management to reject LIFO. Earnings per share (EPS) is a critical
number, and many managements are reluctant to adopt accounting policies that hurt EPS.
The shame of the matter is that the same business events can dramatically affect measures
of performance, depending on whether LIFO or FIFO is adopted. Although, the smart
decision would be to adopt LIFO and buy the 400,000 units, this decision produces the
worst earnings record!

279

7-72

(cont.)

4a.

The income statement for year two would show the same net income and earnings per
share whether additional inventory is purchased or not, because prices do not change.
Note that Do not Buy and Buy headings refer to the action taken last year, so this
year in the calculation of cost of goods sold table, the do not buy columns (columns a and
c) purchases are higher.

In year 2

LIFO
Do not Buy

Sales
Cost of goods sold*
Gross profit
Other expenses
Income before taxes
Income taxes
Net income
Earnings per share

$5,500,000
4,400,000a
$1,100,000
800,000
$ 300,000
105,000
$ 195,000
$
1.95

FIFO
Buy

$5,500,000
4,400,000b
$1,100,000
800,000
$ 300,000
105,000
$ 195,000
$
1.95

Do not Buy
$5,500,000
4,200,000c
$1,300,000
800,000
$ 500,000
175,000
$ 325,000
$
3.25

Buy
$5,500,000
4,200,000d
$1,300,000
800,000
$ 500,000
175,000
$ 325,000
$
3.25

*Year 2 Cost of Goods Sold Calculations

(a)
Beginning inventory, see
parts (1) and (2)
Purchases:
1,700,000 units @ $4
1,300,000 units @ $4
Available for sale
Ending inventory:
200,000 units @ $2 =
600,000 units @ $4 =
600,000 units @ $2 =
200,000 units @ $4 =
800,000 units @ $4 =
Cost of goods sold
4b.

$ 400,000

(b)
$1,200,000

6,800,000
$7,200,000
$ 400,000
2,400,000
1,200,000
800,000

(c)

(d)

$ 600,000

$2,200,000

6,800,000
5,200,000
$6,400,000

$7,400,000

5,200,000
$7,400,000

3,200,000
$4,200,000

3,200,000
$4,200,000

2,800,000
2,000,000
$4,400,000

$4,400,000

FIFO shows $200,000 higher income before taxes ($130,000 after taxes) because 200,000
units of old, lower-cost inventory is in Cost of Goods Sold:
LIFO

FIFO
900,000 units @ $4 = $3,600,000
200,000 units @ $3 =
600,000
$4,200,000

1,100,000 units @ $4 = $4,400,000

280

7-72

(cont.)

4c.

The ending LIFO inventory is $800,000 higher in column (a) because the 400,000 more
units in ending inventory are priced at $4 a unit when the inventory is not replenished at
the end of year one. In column (b), the 400,000 units purchased @ $4 near the end of the
first year were charged immediately to Cost of Goods Sold, leaving 400,000 more of the
ending inventory units at the old unit cost of $2. Under the LIFO assumption, this
inventory is regarded as untouched in the second year, so the old $2 unit cost applies to
the ending inventory of the second year.

4d.
a
$625,000

Income tax for the two years

Alternatives
b
c
$325,000
$775,000

d
$775,000

Unless the LIFO layers are depleted, the adoption of LIFO will result in permanent
postponement of income taxes. However, if the layers are invaded, these low-cost layers
will cause higher tax payments in later years than under FIFO.
4e.

As far as the financial decision is concerned; the computations in part (4) substantiate the
conclusions in part (3). As far as EPS is concerned, note that all EPS numbers decline in the
second year.

7-73

(30 min.)

This problem highlights the fact that LIFO theory of matching current costs against
current revenues breaks down when the so-called LIFO-base inventory is invaded. Then the costs
matched against current revenue are a conglomeration of old (often ancient) costs and current
costs. If prices have been rising for a long time, the income tax liability can be unusually severe:
Sales, 500,000 units @ $3.00
Cost of goods sold:
340,000 @ $2.00 =
30,000 @ 1.20 =
50,000 @ 1.10 =
80,000 @ 1.00 =
Gross profit
Operating expenses
Net income before taxes
Income taxes @ 40%
Net income

Requirement (1)
$1,500,000
$680,000
36,000
55,000
80,000

Requirement (2)
$1,500,000
500,000 @ $2.00

1,000,000

851,000
649,000
500,000
149,000
59,600
$

281

89,400

500,000
500,000

282

7-74

(1520 min.)

1.

Figures are in millions of dollars.

LIFO Cost
20X8
20X9
20
8
14
13

14
13
6
(5)

Sales
Cost of goods sold
Write-down of ending inventory
Total costs charged against sales
Gross margins without write-down
Gross margin after write-down

Lower of LIFO
Cost or Market
20X8
20X9
20
8
14
9
4

18
9
2*

(1)

*Accountants use various formats for presenting the effects of write-downs. Some deduct
the write-down as a special loss immediately after gross margin rather than having it
affect gross margin. Thus, under LIFO some would calculate the standard LIFO gross
margin and then adjust it.
Gross margin
Write-down
Gross margin less inventory write-down

6
4
2

The total gross margin for the two years combined is $1. Note that it is the same for
LIFO and lower-of-LIFO-or-market. The lower-of-cost-or-market method is labeled as
more conservative because it shows gloomier results earlier in a series of periods.
2.

If replacement cost were $10 million on January 31, 20X9, no restoration of the
December write-down would be permitted. In brief, the $9 million December 31 valuation
became the new cost of the inventory. Inasmuch as only write-downs below cost are
allowed in historical cost accounting for inventories, no subsequent write-ups are allowed.

7-75

(1520 min.)

1.

The change in the LIFO reserve is the annual effect on cost of goods sold, in this instance
($203 million $149 million) = $54 million. Because the LIFO reserve increased, the use
of LIFO in this year decreased pretax income by $54 million. Therefore, using FIFO,
pretax income would have been ($792 million + $54 million) = $846 million.

2.

LIFO = .34 $792,000,000

FIFO = .34 $846,000,000
Difference
or
Difference

3.

Yes. Using LIFO reduces taxes in the current year by $18,360,000. The cumulative effect
of the LIFO choice over time can be estimated by multiplying the tax rate times the ending
LIFO Reserve: (.34 $203 million) = $69.02 million. Think of this as an interest-free
loan from the government.

=
=
=
=

$269,280,000
287,640,000
$ 18,360,000
.34 $54,000,000 = $18,360,000

283

7-76

(1520 minutes) Amounts are in millions.

1.

Generally inventory costs have been increasing because the LIFO inventory values were
lower than the FIFO inventory values and LIFO inventory costs are associated with older
purchases.

2.

Gross profit with current inventory method = ($1,000 - $532.6) = $467.4

If Brunswick had always used FIFO, inventory costs would have been $119.8 higher and
gross profit would have been $119.8 lower:
FIFO Gross Profit = ($467.4 - $119.8) = $347.6
In Periods of rising costs and constant or growing inventory, FIFO yields higher gross
profit. During an inventory liquidation, the opposite is true.

7-77

(1015 min.)

O is used for overstated, U for understated, and N for not affected. All amounts are $20
million unless otherwise indicated.
1.

Effects of Fiscal Year

2011
2010
O
N
N
O
O
U
U
O
U
O
U by $8mil*
O by $8 mil*
U by 12 mil**
O by 12 mil**

Beginning inventory
Ending inventory
Cost of sales
Gross profit
Income before taxes
Taxes on income
Net income
*.40 $20 million = $8 million
** (1 .40) $20 million = $12 million
2.

Retained earnings would be overstated by $12 million at the end of fiscal 2010. However,
the error would be offset in the next year assuming no change in the 40% rate of income
tax. Therefore, retained earnings would be correct at the end of fiscal 2011.

284

7-78

(1015 min)

The ethical question is moderated by the fact that such LIFO liquidation decisions are fully
transparent. The financial statements of public companies invariably describe inventory
accounting practices and report the role that LIFO liquidations play in the results.
The academic research has shown that the likelihood of a LIFO liquidation increases significantly
when the firm would otherwise report earnings below the consensus earnings expectation. LIFO
liquidations seem to be examples of earnings management.
7-79

(1015 min.)

1.

Cost of goods sold:

With the purchase, ($1,600 8,000)
Without the purchase, ($750 8,000)
Difference
Income tax savings, (.40 $6,800,000)

2.

$12,800,000
6,000,000
$ 6,800,000
$ 2,720,000

This is an actual case. The only change is that at the time this actually happened the costs
of gold were $300 and $160 rather than the $1,600 and $750 used here. The Tax Court
held that raw materials may be entered as inventory only if they have been acquired for the
purpose of sale in the ordinary course of business or for the purpose of being physically
incorporated into merchandise intended for sale. Therefore, the taxpayers cost of goods
sold should have included the cost of the lower-priced inventory instead of the higherpriced year-end purchase.

285

7-80

(1520 min.)
Gross Profit Percentage
$6,218 $17,260
$6,915 $18,486
$9,774 $32,347
$9,136 $32,510
$6,410 $20,380

=
=
=
=
=

.360
.374
.302
.281
.315

$11,042 $3,065
$11,571 $3,450
$22,573 $4,938
$23,374 $6,004
$13,970 $3,711

=
=
=
=
=

11
09
03

$10,601 $41,567
$12,652 $46,770
$4,504 $30,762

= .255
= .271
= .146

$30,966 $8,679
$34,118 $9,379
$26,258 $5,311

= 3.57
= 3.64
= 4.94

00
95

$7,823 $35,925
$8,033 $34,025

= .218
= .236

$28,102 $6,819
$25,992 $7,317

= 4.12
= 3.55

11
JCPenney 09
03
00
95

Sears/
Kmart

Inventory Turnover
3.60
3.35
4.57
3.89
3.76

Although the problem provides data for only three years, 95, 03 and 11, the solution adds
two additional points of comparison. JCPenney has a consistently higher gross profit percentage
than Sears/Kmart. Inventory turnovers are fairly comparable but both peaked in 03.
Penneys consistently higher gross margin percentage no doubt reflects its chosen market
niche, which places more emphasis on style and fashion and less on price. The Penney product
mix emphasizes soft-goods while Sears includes more appliances and tools.
7-81 (20 min)
1.

Currently inventory will be (4,500 units $40) = $180,000.

If 15,000 more units are purchased, inventory would be 19,500 units, and there would be
a LIFO layer of 2,500 units at $50 per unit and a LIFO layer of 12,500 units at $60 per
unit in addition to the 4,500 units at $40/unit. The total inventory would be $1,055,000.
The important fact is that just as the inventory level changes, so does the cost of goods
sold calculation. The $70 per unit cost of the new 15,000 units would all be part of cost
of goods sold. Thus the 2,500 LIFO layer that cost $50 per unit would be treated as
inventory rather than goods sold. Using $70 per unit instead of $50 per unit for cost of
goods sold for 2,500 units increases cost of goods sold by $50,000 ($20 per unit times
2,500 units). Similarly, using $70 per unit instead of $60 per unit for 12,500 units
increased cost of goods sold by $125,000 ($10 per unit times 12,500 units). The total
increase in cost of goods sold would be ($50,000 + $125,000) = $175,000. This increase
in cost decreases taxable income by $175,000. At a tax rate of 45%, taxes decline by
$78,750.

2.

It is ethically appropriate to minimize taxes. As long as the purchase is consistent with the
ongoing business needs of Yokohama, it is ethical.

286

7-82

(15 min.)

1.
Inventory
135,000
630,000
X

Balance
Balance

610,000

Let X be the ending inventory balance:

X
X
2.

=
=
=

Beginning balance + Purchases Cost of goods sold

$135,000 + $630,000 $610,000
$155,000

Inventory shrinkage = $155,000 $140,000 = $15,000

Inventory shrinkage expense
Inventory
Cost of goods sold

3.

15,000
15,000
=
=

$610,000 + $15,000
$625,000

Inventory shrinkage as a percent of sales is ($15,000 $700,000) = 2.1%. Lola should

look for ways that inventory might be stolen, either by employees or by others. She also
may want to examine the new perpetual inventory system to make sure that all costs of
goods sold are being recorded.

287

7-83

(1520 min.)

1.

An understatement of ending inventories overstates cost of goods sold and understates

taxable income by $500,000. Taxes evaded would be .40 $500,000 = $200,000.

2.

This news story provides a good illustration of why a basic knowledge of accounting is
helpful in understanding the business press. The news story is incomplete or misleading in
one important respect. The business owners understated ending inventory becomes the
understated beginning inventory of the next year. If no other manipulations occur, the
owner will understate cost of goods sold during the next year, overstate taxable income,
and pay an extra $200,000 in income taxes. Thus, the owner will have postponed paying
income taxes for one year, paying no interest on the money borrowed from the
government.
To continue to evade the $200,000 of income taxes of year one, the ending inventory of
the second year must be understated by another $500,000 for a total understatement of
$1 million. However, if only the original $500,000 understatement persists year after year,
the owner is enjoying a perpetual loan of $200,000 (based on a 40% tax rate) from the
government. Data follow (in dollars):

Honest Reporting
First Year
Beginning inventory
Purchases
Available for sale
Ending inventory
Cost of goods sold
Income tax savings @ 40%
Income tax savings for
two years together

Second Year

3,000,000
10,000,000
13,000,000
2,500,000
10,500,000
4,200,000

2,500,000
10,000,000
12,500,000
2,500,000
10,000,000
4,000,000

8,200,000

Dishonest Reporting
First Year

Second Year

3,000,000
10,000,000
13,000,000
2,000,000
11,000,000
4,400,000

2,000,000
10,000,000
12,000,000
2,000,000
10,000,000
4,000,000

8,400,000

Some students may incorrectly reason that understating inventory each year has a
cumulative effect. You may wish to emphasize that the second year has the same cost of
goods sold in each column, because in the dishonest case both beginning and ending
inventory are understated by the same amount. To evade an additional $200,000 of
income taxes in the second year, the ending inventory must be understated by $1,000,000
(not $500,000) in the second year.

288

7-84

(1520 min.)

1.

Raw material used

Wages paid
Depreciation
Studio rent
Total production costs
Cost per unit produced
Cost of goods sold
Ending inventory:
Raw material available
Finished goods
Total inventory

2.

= 1,500 shirts @ $3
=
= 1 month
=
= 1,500 units @ [$5,000 10,000 = .50] =
=
= $7,350 1,500
= 1,200 $4.90

=
=

500 shirts @ $3
1,500 1,200 = 300 shirts @ $4.90

=
=

$4,500
1,600
750
500
$7,350
$ 4.90
$5,880
$1,500
1,470
$2,970

STEPHENS T-SHIRTS
Income Statement for January
Revenue 1,200 shirts @ $10
Cost of goods sold
Income before tax
Tax expense @ 40%
Net Income

$12,000
5,880
6,120
2,448
$ 3,672

7-85

(60 min. or more) Amounts are in millions.

1.

Specific identification depends entirely on assumptions but should give a result that differs
from LIFO and FIFO by no more than about $21, the amount of the LIFO Reserve. In a
world where prices stayed level or rose over time, the inventory under LIFO would be
based on the oldest and lowest costs and the inventory under FIFO would be based on the
newest and highest costs. The inventory under specific identification should be in
between.
Computation of operating income for 20X2:
Cost of goods sold:
Beginning inventory
Purchases
Goods available for sale
Ending inventory
Cost of goods sold
Operating income:
Sales
Cost of goods sold
Gross margin
Other expenses
Operating income

2.

LIFO

FIFO

$169
561
730
169
$561

$181
561
742
190
$552

$1,000
561
439
417
$ 22

$1,000
552
448
417
$ 31

This will be most challenging for the groups doing specific identification.
289

786

(4560 min.)
Each solution will be unique and will change each year. The purpose of this problem is to
recognize different inventory methods and their relationship to gross profit percentage and
inventory turnover.

787

(3545 min.) Amounts are in millions of dollars.

Inventory Calculation

1.

Inventory
543.3

Beg. Inv. + Purchases Cost of sales = Ending Inv.

$543.3 + Purchases $3,959.4 = $965.8

965.8

Purchases = $4,381.9

4,381.9
3,959.4*
Purchases =
$3,959.4 +
$965.8

$543.3
*($4,949.3 .8) = 3,959.4
2.

Inventory turnover
Inventory turnover

3.

Fiscal Year

= cost of sales average inventory

= $3,959.4 [($543.3 + $965.8) 2]
= $3,959.4 $754.6
= 5.25
Gross margin sales

2011

($11,700.4 $4,949.3) $11,700.4 = 57.7%

2010

($10,707.4 $4,458.6) $10,707.4 = 58.4%

2009

($9,774.6 $4,324.9) $9,774.6 = 55.8%

The gross margin percentage rose in 2010 but fell back toward the 2009 level in 2011.
Gross margins for Starbucks are high. This is because of the industry and Starbucks
strategy. Starbucks charges a premium price for its coffee and other drinks.

290

7-88

(3060 min.)

NOTE TO INSTRUCTOR: This solution is based on the Web site as it was in late 2012 and uses
numbers from the 2011 annual report. Be sure to examine the current Web site before assigning
this problem, as the information there may have changed.
1.

In 2011 Teva represented ($118,742 $1,377,283) = 8.6% of Deckers sales. This

percentage is down from ($82,003 $448,929) = 18.3% in 2007. UGG is the largest
brand representing ($915,203 $1,377,283) = 66.5% of 2011 sales. These numbers are
calculated from information in item 6 of the 10-K which provides selected financial data
for Teva and other subsidiaries.

2.

Inventories are reported at the lower of FIFO cost or market. The costs of inventories are
probably not increasing fast enough to give LIFO a large tax advantage. Using LCM is
important to a company such as Deckers because shoes can become out-of-style and
therefore have market values below cost.

3.

In 2011 the gross profit was $678,995,000, up from $502,938,000 in 2010. The gross
profit percentage decreased from ($502,938 $1,000,989) = 50.2% in 2010 to
($678,995,000 $1,377,283,000) = 49.3% in 2011. The Management Discussion and
Analysis refers specifically to high demand for the sheepskin used in Deckers products,
and associated cost increases, which put pressure on the profit margins.

291